Staking Crypto: How It Works

Learn about how staking crypto on blockchains works, its pros and cons, and how to stake on

Dec 29, 2022

What Staking Opt

Key Takeaways:

  • Staking and lock-ups are a way for crypto holders to passively receive rewards from their cryptocurrency holdings, which might otherwise be sitting idle in a crypto wallet. 
  • Typical ways to stake include becoming a validator for a Proof of Stake (PoS) blockchain, joining a staking pool, or using a lock-up service offered by cryptocurrency exchanges.
  • However, there are some considerations and risks to take into account before staking, including market price movements, lock-up periods, fees, and validator penalties.

What Is Staking?

Staking can be a way for market participants to receive rewards from their cryptocurrency holdings. These rewards are also referred to as staking yields. 

Yield is a concept that exists in traditional finance, though the mechanics of how it is earned in crypto may be wholly different. For instance, a form of yield in traditional finance is when people put their money into a bank savings account to earn interest. Traditional financial assets that provide a yield could be bonds that pay a regular coupon or stocks that pay a dividend. In a sense, the rental income people receive from letting properties could be described as a form of yield.

In the case of depositing funds in a bank savings account, the bank is able to pay yield in the form of interest typically by taking the money and lending it out to others. In contrast, for crypto staking, the cryptocurrency is locked up in order to participate in running the blockchain and maintaining its security.

How Does Staking Work?

In order to understand how staking works, let’s first look at what Proof of Stake (PoS) blockchains are. 

  • Consensus mechanisms: A blockchain is essentially a digital ledger used to record transactions. These transactions need to be verified and agreed upon (reach a consensus) by many different computers (called validators in PoS) in a blockchain network before they can be added to the chain. This is where consensus mechanisms (also known as consensus protocols or consensus algorithms) come into play. There are many different types of consensus mechanisms, but one of the main ones is Proof of Stake (PoS).

Read more about different blockchain consensus mechanisms in this beginner’s guide.

  • Proof of Stake (PoS): In PoS blockchains, transactions are verified, or validated, by validators, who have to stake an amount of a blockchain’s native token in order to participate in the verification process. In return for doing this, validators typically get rewarded in the blockchain’s native token. If they engage in malicious behaviour, or fail to validate (e.g., by going offline), a portion of their stakes could be taken away. Validators need some specific computer hardware and software in order to participate. 

By staking their cryptocurrency, validators are able to help keep the PoS networks secure and receive rewards while doing so. Some blockchains, such as Ethereum, which recently transitioned to PoS in a much-anticipated event called ‘The Merge’, require validators to stake quite a large amount of native tokens. In Ethereum’s case, the current minimum requirement is 32 ETH

Learn more about what Ethereum’s ‘The Merge’ is.

Ways of Staking Cryptocurrency

  • Become a validator: This typically involves a required staking amount of cryptocurrency (which could be sizeable), specific computer hardware and software, time, and knowledge to perform the validation tasks.
  • Join a staking pool: Some validators operate staking pools that pool together many users’ smaller stakes. This is also known as ‘liquid staking’, which involves a liquidity token that represents a user’s staked coin and the rewards it generates. The validators will do all the transaction validation work and distribute the rewards to stakers proportionally after deducting their fees.   
  • Lock-up tokens with exchanges: A number of cryptocurrency exchanges offer lock-ups that also essentially pool together many users’ tokens. Users can choose which cryptocurrency and how much they want to lock-up, which will determine their share of the rewards.

What Are the Benefits of Staking and Locking Up Crypto?

Staking and lock-ups are a way to receive rewards from cryptocurrency holdings that might be otherwise sitting idle in a crypto wallet. Staking and lock-up rewards are typically expressed in annual percentage rate (APR) terms. For example, a 5% APR means a holder would, in theory, receive $5 annually for every $100 worth of crypto staked, noting that the cryptocurrency’s price will likely fluctuate over the course of the staking period. Different cryptocurrency lock-up options have different APRs and can be compared. 

Staking is an integral part of a PoS blockchain. In a way, users are ultimately contributing to a process that is critical to the security and operation of the blockchain.

Considerations When Staking Cryptocurrency

There are some risks and downsides to consider when staking or committing tokens to a lock-up:

  • Price movements and total return: While staking lets users receive yield, an important consideration is the concept of total return, a combination of capital appreciation (or loss) and the yield received. For example, if $100 of a cryptocurrency is purchased and staked for a 10% yield, the reward from staking would be $10. However, if the cryptocurrency price dropped by 30%, there would be a capital loss of $30. Overall, it’s a loss because the capital loss is more than the yield received.
  • Lock-up period: Some tokens have minimum lock-up periods where users cannot withdraw their tokens. Furthermore, when withdrawing tokens from a staking pool, there could be a specific waiting time for each blockchain before the tokens are received. So if a user wants to use their crypto for other purposes (such as trading) during a particular period of time, they may not want to lock it up. 
  • Validator penalties: If a user joins a staking pool, a risk could be that the validator fails to perform their tasks properly or engages in malicious behaviour. These improper validator actions may be penalised by having their rewards cut or the staked amount taken away, potentially affecting the users who joined the pool as well. 
  • Fees: Staking pools and crypto exchanges offering lock-ups also may charge fees or commissions to users. 
  • Hacks: It is also possible that staking pools could be hacked or have a vulnerability that is exploited, potentially resulting in a complete or partial loss of the locked-up funds.

Conclusion — Should You Stake Crypto?

Staking and lock-ups are a way to passively receive rewards on cryptocurrency holdings. Some typical ways to participate in staking are to become a validator for a PoS blockchain, join a staking pool, or use a lock-up service offered by crypto exchanges. However, there are some risks and downsides to consider, including validator penalties, market price movements that could affect the total return, hacks, fees, and the lock-up period.

Lock-up With Earn

You can lock-up a variety of tokens or contribute your stake to a validator pool on a token’s native chain in the DeFi Wallet.  

Simply navigate to the ‘Earn’ tab in the DeFi Wallet and select a token marked with ‘staking’. For example, for more details on staking Cosmos chain’s native ATOM, check out this comprehensive guide.

Due Diligence and Do Your Own Research

All examples listed in this article are for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained herein shall constitute a solicitation, recommendation, endorsement, or offer by to invest, buy, or sell any coins, tokens, or other crypto assets. Returns on the buying and selling of crypto assets may be subject to tax, including capital gains tax, in your jurisdiction. Any descriptions of products or features are merely for illustrative purposes and do not constitute an endorsement, invitation, or solicitation.

Past performance is not a guarantee or predictor of future performance. The value of crypto assets can increase or decrease, and you could lose all or a substantial amount of your purchase price. When assessing a crypto asset, it’s essential for you to do your research and due diligence to make the best possible judgement, as any purchases shall be your sole responsibility.

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